Increasingly controversial, the Exchange Stabilization Fund is used
to influence the international value of the U.S. dollar and to provide
aid to foreign countries. The debate surrounding the Fund will become
more informed, suggest the authors, when observers understand how to
calculate the total amount of resources available to the Fund. This
Economic Commentary explains how the ESF's balance sheet figures
must be adjusted to produce an accurate account of those resources.

The increased turmoil in international financial markets, starting
with the Asian crises of 1997, has led to calls for financial assistance
from the wealthier nations. In December 1997, the United States announced a $5 billion commitment toward an international package of
financial assistance for South Korea. Two months earlier the United
States pledged $3 billion for assistance to Indonesia. In both
instances, the Exchange Stabilization Fund (ESF) was to be involved.

Established by Congress in 1934 to help stabilize the international
value of the dollar, the ESF received little public attention until it
was used in the provision of financial assistance to Mexico in the wake
of the peso crisis of 1995. Indeed, greater scrutiny may have been
inevitable given the ESF's expansion beyond its original mandate.
[1] Despite the recent attention, the full range of ESF activities and
the actual amount of available ESF resources are not well understood.
This impedes an informed public discussion of ESF operations.

A major goal of this Economic Commentary is to facilitate accurate
assessments of the amount of resources available to the ESF. First, in
order to understand the uses of ESF resources, we provide an overview of
ESF operations. Second, we examine the ESF balance sheet to show how
"total assets" is a poor measure of the resources available to
the ESF for one of its major activities, foreign-exchange intervention.
Third, we discuss how any measure of ESF resources must take account of
warehousing and swap lines. Finally, we suggest a better procedure for
assessing the amount of resources available to the ESF.

* An Overview of the ESF

The ESF began operations on April 27, 1934, with capital of $2
billion. Initially, $1.8 billion of the ESF's reserves were
maintained in the Treasury's gold account. The remaining $200
million was deposited in a special account at the Federal Reserve Bank
of New York as the working balance for investing in gold and foreign
exchange. [2] The working fund of the ESF has expanded over time,
reaching as high as $42 billion in mid-1995. [3] As documented by
Schwartz (1997), most of the growth in ESF assets has occurred since
1960 and has comprised increases in foreign exchange and securities. As
of June 30, 1998, almost 60 percent of the asset total had been financed
by cumulative net income, mainly reflecting interest earnings and
capital gains on foreign currencies.

The Gold Reserve Act of 1934 excluded the ESF from the
congressional appropriations process and explicitly authorized it to
operate without congressional oversight and accountability. In other
words, Congress gave exclusive control of the ESF to the executive
branch. All decisions regarding the ESF are made by the Secretary of the
Treasury, subject to the approval of the President.

Legislative changes in the late 1970s reduced somewhat the secrecy
under which the ESF operates and made it more accountable to the
Congress. For instance, since 1979 the administrative expenses of the
ESF have been subject to the budget process. Moreover, a 1977 amendment
to Section 10 of the Gold Reserve Act provides that: "... a loan or
credit to a foreign entity or government of a foreign country may be
made for more than 6 months in a 12month period only if the President
gives Congress a written statement that unique or emergency
circumstances require the loan or credit be for more than 6 months (31
U.S.C. 5302(b))."

Finally, 1978 legislation requires the Treasury to provide monthly
statements of ESE activities to the House and Senate Banking Committees.
Nevertheless, none of these legislative changes has reduced the
discretion of the Treasury Secretary in operating the ESF All of his
decisions are final and not subject to approval by the Congress.

* The Size of the ESF

A common misperception about the ESF is that its size is adequately
measured by the "total assets" number reported on the ESF
balance sheet, published quarterly in the Treasury Bulletin (see table
l). [4] This might seem to be a reasonable presumption since the ESF
cannot unilaterally issue debt in financial markets. However, several
important aspects of ESF operations are not apparent from its balance
sheet. In particular, since many ESF operations use dollar assets, any
limitation on the conversion of nondollar assets to dollar assets is
relevant to an assessment of available ESF resources.

Intervention, the purchase or sale of foreign currencies to
influence the international value of the dollar, is a major use of ESF
resources (see box, opposite). The other is the provision of financial
assistance to foreign countries. Whenever the ESF sells foreign
currency, it produces a crediting of the ESF's (nonmarketable) U.S.
government security account with the Treasury, which is equivalent to
"dollar" cash assets. When purchasing foreign currency, the
ESF first obtalns dottar balances-possibly by selling some of its
Treasury securities to the Treasury (with the Federal Reserve
[hereafter, the Fed] acting as agent). The subsequent purchase of
foreign exchange with dollars leaves the ESF with a lower level of
Treasury securities but an offsetting increase in "foreign exchange
and securities."

Thus the relevant measure of resources available for ESF
interventions depends on whether foreign exchange is being bought or
sold. Dollar assets are needed to buy foreign-currency-denominated
assets. On the other hand, purchases of dollars are financed from
international reserves, which include official holdings of gold, foreign
government securities or deposits at foreign central banks, the reserve
position in the International Monetary Fund (IMF), and special drawing
rights (SDRs). [5]

ESF accounting for SDRs provides another example of why total
assets is a poor measure of available resources. The SDR is an
international reserve asset created by the IMF (under the First
Amendment to its Articles of Agreement) to supplement existing reserve
assets. The value of an SDR is determined by reference to a basket of
currencies of the five largest industrial-economy member countries of
the IMF. Pursuant to the Special Drawing Rights Act of 1968, SDRs
allocated to the United States or otherwise acquired by the United
States are resources of the ESF.

The third entry, "SDR certificates," equals the portion
of the SDR assets which has already been "used." As noted
earlier, all SDRs owned by the U.S. government must beheld by the ESF.
In other words, the ESF cannot engage in transactions with either the
U.S. Treasury or the Fed that would result in a reduction in the
ESF's SDR holdings. Thus, in order to convert SDRs to
dollar-denominated assets, the BSF issues a claim on its SDR assets to
the Fed- SDR certificates-in a process called monetization. [7] While
this does not decrease the SDR asset entry on the balance sheet of the
ESF, it does increase the certificate number by the amount of the
monetization. By law, the certificate entry cannot exceed the SDR asset
entry. However, up to the limit imposed by the SDR asset total,
monetization increases the size of the balance sheet, since the
certificate amount increases dollar for dollar with the eventual
purchase of assets (for example, foreign-currency-denominated government
securities). [8]

There are three SDR entries on the ESF balance sheet (see table 1).
The SDR asset entry and the SDR liability entry, "SDR
allocations," pertain to ESF linkages to the IMF. The allocations
represent the current value of the provisions of SDRs by the IMF to the
U.S. Treasury, which were transferred to the account of the ESF. [6] The
SDR asset entry reflects the dollar value of SDR allocations to the
United States plus interest earnings, valuation changes, and sales and
acquisitions of SDRs from other IMF participants.

Since the monetization process increases the total asset number
while decreasing the amount of SDRs available to be monetized, the
certificate total must be subtracted from total assets to arrive at an
estimate of the ESF's available resources. Thus, although total
assets of the ESF on June 30, 1998, were S39.7 billion dollars, a
slightly more accurate measure of available dollars would be $30.4
billion. This is the sum of the nonmonetized portion of the SDR total
($10 billion SDRs minus $9.2 billion SDR certificates), the entry for
U.S. government securities with the Treasury ($15.7 billion), and the
dollar value of the German mark and Japanese yen items ($13.9 billion).

* Off-Balance-Sheet Financing Congress limited the ability of the
ESF to issue liabilities on its own and thus, perhaps intentionally,
limited the ESF to financing new interventions through the sale of
assets, a practice known as asset management. However, beyond the uses
of SDRs and securities as described above the BSF can obtain additional
dollar resources by moving foreign-denominated assets off-balance sheet
through an arrangement with the Federal Reserve System. Thus, the $30.4
billion on-balance sheet asset number is still a flawed measure of the
dollar assets available to the ESF.

The first problem is that, once the Treasury securities
("dollars") are exhausted, the ESF cannot use its German mark
assets or Japanese yen assets to purchase additional mark or yen items,
respectively, without first converting them into dollar-denominated
assets. This conversion of the ESF's foreign currency portfolio
into dollar-denominated assets requires an off-balance-sheet financing
arrangement with the Fed, referred to as warehousing. Warehousing is a
swap transaction in which the Fed buys foreign exchange from the ESF in
a spot transaction and sells it back with a forward transaction--that
is, the ESF agrees to exchange dollar assets for foreign exchange on the
date the forward transaction comes due. The ESF balance sheet would thus
record a decline in "foreign exchange and securities" but an
increase in the "U.S. government securities" total, which
could be used to purchase foreign currency or implement dollar loans to
foreign countries (the forward transaction would not appear). In other
words, the Fed warehousing arrangement allows the ESF to take a
leveraged position in foreign assets that is not reflected on the
ESF's balance sheet.

Two factors complicate the ESF's ability to use the Fed
warehouse. First, the size of the warehouse is determined by FOMC deliberations. Although the size of the warehouse was increased to $20
billion to help finance the Mexican financial assistance package in
1995, it is currently limited to $5 billion with no balances currently
outstanding. Second, although the currencies currently eligible for the
warehouse are indicated in the Authorization for Foreign Currency
Operations, they are not necessarily the same as the currencies that the
ESF needs to exchange. [9]

Since about 1978, warehousing has been controversial. Goodfriend
(1994) argues currency-warehousing agreements between the ESF and the
Fed provide the ESF with additional funding that circumvents the
congressional appropriations process and statutory limits on Federal
borrowing. [10]

The second problem with the on-balance-sheet asset measure of ESF
resources is that it ignores swap lines. Swap lines, formally called
reciprocal currency arrangements, are credit lines between governments
(or central banks) stipulating terms which, usually for a short period
of time, allow either country to borrow the other's currency. [11]
The mechanics of drawing down a swap line are similar to that of
warehousing--offsetting spot market and forward market
transactions--except that our swap lines do not provide us with dollar
assets directly but rather provide dollar assets for the other country.
As in the warehousing arrangement, the forward market transaction does
not appear on the balance sheet until the expiration of the swap line.
[12] Drawings might be renewed once routinely, but statutes require that
the executive branch report subsequent renewals to Congress. Both the
Fed and the ESF maintain swap lines the sizes of which are indicated in
the quarterly summary of ESF and Fed foreign exchange operat ions
published in the Federal Reserve Bulletin. As of March 31, 1999, the
only authorized ESF swap line was with the Bank of Mexico for $3
billion. [13]

Finally, any measure of ESF resources available for intervention
needs to take account of any stated commitments by the U.S. Treasury to
provide financial assistance to foreign governments via the ESF. For
instance, the commitments that had been made to Korea and Indonesia
would have reduced the total resources available for intervention as
reflected on the June 30 balance sheet by $8 billion. [14]

Summary

The Exchange Stabilization Fund, under the U.S. Treasury, is now
routinely involved in efforts to stabilize currencies and to provide
financial support to foreign countries. However, the amount of resources
available to the ESF and its range of activities are perhaps not well
understood by many observers. In this Economic Commentary we correct the
misperception that "total assets" is a good measure of
available ESF resources.

First, "total assets" ignores the fact that the
monetization of SDRs does not decrease the SDR asset entry even though
the total amount of monetization is limited by the SDR asset number.
Consequently, total assets must be reduced by the outstanding amount of
monetization, measured by the SDR certificate number. Second, estimates
of resources available to the ESF for intervention must take into
account the warehousing arrangement with the Fed. The current limit on
the size of the warehouse is relevant to whether the
foreign-currency-denominated assets could be converted into dollars for
use in purchasing foreign assets. Third, outstanding swaps and any
existing commitments of ESF funds should be reflected in estimated ESF
resources. An understanding of these points is a prerequisite to an
informed debate regarding any change in ESF funding.

(2.) Although originally authorized to deal in both gold and
foreign exchange, the ESF has tended to deal primarily in foreign
exchange and, to some extent, in the securities of sovereign nations
(including U.S. government securities).

(3.) See Schwartz (footnote 1), pp. 136-7.

(4.) For example, a December 4, 1997, article discussing the
proposed rescue plan for South Korea states that "the U.S. money,
if needed, would come from the Exchange Stabilization Fund.... The fund
contained $40 billion as of the end of March...." See "South
Korea, IMF Finalize $55 Billion Bailout Plan," Los Angeles Times,
p. Dl.

(5.) The U.S. drew on its IMF quota in 1964- 66, 1968, 1970-72, and
1978 for amounts totaling $6.5 billion. Treasury securities denominated
in foreign currencies were issued in 1962-74 ("Roosa" bonds)
and in 1978-79 ("Carter" bonds) for $11.1 billion. See
Schwartz (footnote 1), pp.143-4.

(6.) These IMF provisions of SDRs to the U.S. Treasury occurred in
four separate actions between 1970 and 1981.

(7.) The last big cash-in, or conversion of, SDRs was in the third
quarter of 1995 to fund part of the financial assistance offered to
Mexico.

(8.) The conversion of SDRs first augments the asset-side entry for
U.S. government securities. This entry, plus "foreign exchange and
(foreign government) securities" more directly permits the funding
of ESF activities such as the purchase and sale of foreign currencies.
For example, U.S. government securities can be used to purchase foreign
currency as part of an effort to depress the international value of the
dollar. This would then add to the foreign exchange total, which is
largely held in the form of foreign currency government securities,
rather than cash.

(9.) The authorization is published annually in Annual Report of
the Board of Governors of the Federal Reserve System. See also Owen F
Humpage, "Institutional Aspects of U.S. Intervention,"
Economic Review, Federal Reserve Bank of Cleveland, vol. 30, no. I
(Quarter 1 1994), p. 5.

(11.) See Humpage (footnote 9), pp.7-8, for further details on the
accounting associated with swap lines.

(12.) Because a forward transaction commits the ESF to exchange
foreign currency for dollars at a fixed price in the future, the true
exposure of the ESF to foreign-exchange risk is not reflected on its
balance sheet.

(13.) In the last quarter of 1998, Federal Reserve System swap
lines were reduced from $32.4 billion to $5 billion ($2 billion with the
Bank of Canada and S3 billion with the Bank of Mexico), and the ESE
eliminated its swap line with the German Bundesbank. There are no
outstanding swaps for either agency. Reasons stated for the reductions
included history of disuse, formation of the European Central Bank, and
the existence of other arrangements for monetary cooperation.

(14.) The commitments to Korea and Indonesia and also to Thailand
have since been rendered inoperative. However, as of June 1999, the ESF
still provides backstop to the Bank of International Settlements'
$7.5 billion dollar support package for Brazil.

William P Osterberg is a senior economist at the Federal Reserve
Bank of Cleveland, and James B. Thomson is a vice president and
economist at the Bank. The authors are grateful to Tim Dulaney, Owen
Humpage, Dino Kos, and Walker Todd for numerous helpful comments and
suggestions.

The views stated herein are those of the authors and not
necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve System.

ESF BALANCE SHEET, JUNE 30, 1998
($ millions)
Assets
Held with U.S. Treasury:
U.S. government securities 15,691
Special drawing rights (SDRs) 10,001
Foreign exchange and securities:
German Market 5,898
Japanese yen 8,018
Accounts receivable 119
Total Assets 39,727
Liabilities and capital
Current liabilities:
Accounts payble 223
Total current liabilities 223
Other liabilities:
SDR Certificates 9,200
SDR allocaitons 6,524
Total other liabilities 15,724
Capital:
Capital account 200
Net income gain (+)
of loss (-) 23,581
Total capital 23,781
Total liabilities and capital 39,727 [a]
(a.)The column sum does not equal this
number because of rounding error.
SOURCE: U.S. Department of the Treasury,
Treasury Bulletin, December 1998, p. 108.

THE FED AND THE ESF IN FOREIGN-EXCHANGE INTERVENTION

Since the ESF's inception, the Federal Reserve Bank of New
York has been the officially designated agent for the ESF in
intervention operations. In 1962, the Federal Reserve System's
Federal Open Market Committee (FOMC) authorized open-market transactions
in foreign currencies for the account of the Fed, and since then, the
Federal Reserve Bank of New York has acted as agent for both the Fed and
the ESF in such transactions. Starting in 1978, the ESF and the Fed have
almost always intervened jointly.

Although the decision to intervene is usually made jointly by the
Treasury and the Fed, it falls primarily under the Treasury's
purview. While the two entities routinely intervene in the same
direction and amounts for their individual accounts, formal independence
is maintained. In other words, the Treasury can instruct the Fed to
intervene on behalf of the ESF but it cannot force the Fed to intervene
for the Fed's own account. [a]

(a.) One exception to this would be a declared national emergency.
See also Owen F. Humpage, "Institutional Aspects of U.S.
Intervention," Economic Review, Federal Reserve Bank of Cleveland.
vol. 20, no. 1 (Quarter 1 1994), pp. 2-19.

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